The Low-Load Annuity Advantage

If you think you are a candidate for an annuity, go low-load. Their costs are small, compared with the rest of the products on the market, and you can take out your money whenever you want, without paying a penalty. Low costs, total flexibility. Why would you look at anything else? It may take only 10 or 12 years for a low- load to start doing better than outside mutual funds, after tax.

Low-load annuities are available through fee-only financial planners. Here are five low loads you can buy yourself:

Taking Your Money out of an Annuity When You Retire

The insurance company gives you several options:

• Take a lump sum.
• Take the money in a fixed number of guaranteed payments. If you die before the term ends, a beneficiary can collect the remaining payments.
• Take a fixed monthly income for life, for yourself or yourself and a beneficiary.
• Take a lifetime income, including a guaranteed payment for a period certain, such as the first ten years. If you die before the period is up, a beneficiary will collect the payments for the remaining term.
• Take systematic withdrawals based on your life expectancy, if your contract allows it. At 65 you will—on average—reach almost 85. So you draw on your annuity as if you had about 20 years to live. By 75, your life expectancy will have lengthened to nearly 87, which changes the size of the monthly payments you can take. If the annuity also covers your spouse, payments can be jiggered to reflect your joint life expectancy. You can also take extra payments from time to time. If the value of your investment drops, however, the annuity may expire earlier than you expected. Note that your interest rate isn’t locked in. If you re using a fixed annuity, it will change from year to year. If you have a variable annuity, you’ll get whatever the contract earns.

Alternatively, when you first buy the annuity, you can attach a flexible lifetime income rider, explained below.

The New, Attractive Nuisance: Variable Annuities with Lifetime Income Options

This is a difficult subject to write about. On the one hand, the option sounds irresistible to baby boomers looking toward retirement. You get the safety of principal, a guaranteed lifetime income, potential for growth in your investment, and access to your money if your circumstances change. Your income can rise but never fall. You always get at least 100 percent of your original investment back. If you die, any money remaining in the contract goes to your heirs.

This is a simplified version of how these annuities work. The mechanics are far more complicated than the versions I’m giving here. Each contract has its own wrinkles, so the companies are hard to compare. The prospectus that “explains” how your future income and benefits are figured is incomprehensible (never a good sign). But in general, here’s what you’re being sold:

The guaranteed minimum lifetime withdrawal benefit—by far the most popular choice today.

• It’s for people who want to start withdrawing an income from their annuity right away or after a limited number of years. It’s sold, especially, to new retirees who are rolling over an IRA or 401(k) account.
• This benefit lets you withdraw a fixed percentage of your original investment each year—typically 5 percent but sometimes more—regardless of how well the investments in your annuity perform. That’s not a 5 percent return on your investment, as some buyers think. It’s a fixed-dollar payout from your annuity account. If you invest $100,000, for example, you’ll get $5,000 a year (5 percent). Your annuity is invested in stocks and bonds. In a year when its value rises substantially, that $5,000 will be paid partly out of your investment earnings. In a year when your annuity’s value increases only modestly or falls, $5,000 will be paid partially or entirely out of your original capital.
• Your guaranteed lifetime monthly withdrawal amount might increase, but only if the value of your investments rises by more than a certain amount. You’ll need a spousal rider if you want the withdrawals to last for your spouse’s lifetime too. If you need more money, you can withdraw more than the guaranteed minimum at any time, but in that case, you’ll lose the lifetime-income guarantee.
• If you die before your original investment has been returned, the remainder’s paid to a beneficiary. (The death benefit is calculated in a variety of ways, depending on the contract.) You have to pay careful attention to how the annuity is titled if you want any benefits to going to your spouse.

You might earn that 8.75 percent over time if you invest your entire annuity in stocks. The salesperson will probably show you that scenario, to make the deal look good. More likely, you’ll invest in a balanced portfolio of stocks and bonds, which is unlikely to yield the high returns you’ll need. Basically, you’re probably buying a fixed lifetime income at a much higher price than you’d pay if you bought a simple, old-fashioned, immediate-pay annuity. If you want to get out of the investment, you’ll pay a surrender charge.

I priced a comparison between a VA with lifetime benefits and an immediate- pay the annuity for a 66-year-old man—both of them guaranteeing $500 a month for life. The difference will surprise you. The fancy VA contract cost $109,900. The immediate-pay annuity cost only $66,900—for the same minimum benefit! Ah, you say, but VA gives you access to your money if you want it, while the immediate- pay annuity locks you in. I say that’s a pretty high price to pay for access.

So, here’s a better idea: Buy the immediate annuity for $66,900. Put the remaining $43,000 into a mix of money market funds and diversified stock-owning mutual funds. The money market funds give you ready access to cash.

The stock funds give you long-term growth.

The tax rate on the gains is much lower than you’d pay on gains in the annuity. And you get the same amount of guaranteed income for life.

• The guaranteed minimum income benefit—for people who want a future lifetime income, guaranteed. The insurance company promises that after a certain number of years, you can opt for a guaranteed minimum level of monthly payments, regardless of how well the market performs. For example, say that you’re guaranteed 5 percent compounded annually over ten years. When ten years are up, you have two choices:
  1. Take the actual dollar value of the annuity in a lump sum. It might be worth more or less than your guarantee (probably less, after annual expenses of 2.5 to 3 percent).
  2. Turn the investment into a lifetime income (or an income for a fixed number of years), based on the 5 percent guarantee. The guarantee is good, even if the investments didn’t perform that well, after expenses.
  What’s not to like? This rider is often sold deceptively. You think that if you annuitize, your payments will be based on a 5 percent return after expenses. Actually, you’ll get less because of the way the insurance company prices the annuity. Your effective return might be something closer to 3 percent, but you’d have to be an actuary to figure it out. These deals are cheats. You might do better by cashing out and buying a lifetime annuity elsewhere. You might also decide—when the term comes to an end—that you don’t want to annuitize after all. In either case, you’ll have paid all those fees for nothing.
• The guaranteed minimum accumulation benefit—for people who want absolute safety plus a chance for their money to grow. The insurance company guarantees that after ten years, your annuity will be worth at least what you paid for it, even if your investments have declined in value.
  What’s not to like? The fee you pay for this rider is a waste of money. I asked Alexa Auerbach of Ibbotson Associates the following question: What’s the chance that a well-diversified investor will lose money over 120 months (10 years), with dividends reinvested? She tested three portfolios—all Treasury bonds, all stocks (Standard & Poor’s 500-stock index), and a 50-50 split between stocks and bonds—over 376 periods, starting in 1965. Guess what? You would never have lost any money, even in the worst month of the 2008 collapse. Most 10-year returns were in the triple digits. You’re probably paying the insurance company for nothing.

Complaints filed with regulators about these annuities are riding high, sales materials are murky, and the products are hard to understand—not only by you but by the brokers and planners who sell them. Complicated products almost always disappoint, especially those that carry high sales commissions! I recommend against.

A Danger to the Insurance Industry?

These new and untested guarantees are risky for insurance companies too. Back in 2002, two insurers got into serious trouble by selling variable annuities with a guaranteed death benefit. The stock market performed poorly, and the companies unexpectedly had to come up with more capital to support the contracts. No consumer lost money (fortunately), but the companies almost failed. Today’s new, living- benefit contracts are even riskier to an insurer’s health, not only due to market risk but because it’s not expensive for consumers to withdraw extra money from the annuities. The industry could be courting trouble all over again. In fact, several insurers struggled during the 2008 market collapse. The companies offering the highest and best guarantees are usually the most vulnerable. They’re already raising fees, which lowers the benefits that investors can expect.

You Shouldn’t Think About Buying Even a Low-Load Variable Annuity Unless You Can Answer All of the Following Questions “Yes”

Have you put the maximum into your tax-deferred retirement plan?
That comes first because those contributions can be deducted from tax. You might also want to add any after-tax money that your plan accepts.

Have you funded a Roth IRA if you’re eligible?

Will you start young enough to make the annuity’s tax deferral pay?
For regular annuities, you usually need a holding period of 15 years or more; for low-load annuities, ten years or more.

Will you invest the annuity money entirely in stocks?
You need superior long-term gains to overcome the annuity’s costs and yield a halfway decent return.

Will you leave the annuity alone until you reach 59 1/2?
Prior withdrawals will cost you a 10 percent tax penalty.

Is this investment primarily for you rather than for your heirs?
If not, your heirs would instead you bought straight mutual funds. They’ll owe income taxes on the deferred gains in inherited annuities. They could receive unrealized gains in mutual funds income-tax free.

Is your tax bracket high?
In low brackets, variable annuities may never outperform mutual funds outside the annuity.

Are Your Variable Annuities Safe?

Yes, if you mean safe from an insurance company failure. The assets are held in a separate account. The value of your annuity is based on the value of the assets behind it. Your lifetime-income guarantees should be good if your company is taken over by another insurer, but it’s unclear what would happen if your company went into receivership.